ONE SWALLOW DOESN'T make a summer and many believe that a few days of rebound in the Shanghai market doesn’t drive away the bearish mood. There is no question that the fall below the long-term trendline is particularly significant. It changes the nature of the trend in the market and the nature of the trend behaviour. The long-term trendline will now act as a formidable resistance to future rises in the trend. The shallow slope of the long-term trendline suggests a slower rate of a future trend rise for the Shanghai market. This is a good outcome because it will develop a more stable and sustainable uptrend.
Fundamental analysts use arbitrary measures to distinguish between a retracement and a bear market. The measures of 10% for a technical correction and 20% for a bear market are convenient, but misleading ways to gauge market behaviour. They do not take into account the behaviour and development of trends. In an environment where the Dow Jones can rise or fall routinely by 3.5% or more a day, it makes little sense to define a technical correction based on a 10% figure.
The characteristics of a bear market are related to the behaviour of the trend and not to a particular figure. This difference is very important when we consider the Shanghai Composite Index. A bear market is preceded by strong and clear chart patterns which give early warnings of a major change in the trend. The most common is the head-and-shoulder pattern. The rounding-top pattern is also a relievable leading signal of trend change. Both these chart patterns developed over several months. The head-and- shoulder pattern in the Shanghai Composite Index started in June 2007 and was confirmed six months later in January 2008.
When we look at the Shanghai Composite Index behaviour in recent weeks or months, we cannot identify one of these bear-market patterns. There is no rounding-top pattern. There is no head-and-shoulder pattern. These patterns forecast a significant and prolonged change in the trend. Without these patterns, the significance of the recent index retreat and trend change is analysed differently.
Further analysis indicates the market is showing the opportunity to apply Strategy 8 from the Chinese 36 Strategies. This is a Secret Escape Through Chen Cang. Analysts are focused on the bear market development, or distracted by the idea of a bubble collapse. They ignore the developing Relative Strength Index (RSI) divergence pattern. The rally rebound in the last several days has confirmed this RSI divergence. This points the way to the secret escape from the bear market.
Divergence occurs when two trendlines move in opposite directions during the same time period. Analysis starts with the Shanghai Composite Index chart. The first trendline is drawn between the low of Aug 20 and the low of Sept 1. This trend line slopes downwards.
The next step is to consider the RSI indicator display. These index lows are compared to the low points on the RSI indicator for the same dates. These two RSI lows are joined with a trendline. This trendline moves upwards and confirms the RSI divergence pattern. This is a powerful and reliable trend reversal pattern. This pattern strongly suggests this market will develop a recovery uptrend.
The RSI divergence pattern has one problem — it is not very good for understanding the time frame for the market recovery. When the divergence pattern develops, it does not mean the market will instantly recover and change the trend direction. The RSI divergence pattern warns that the current trend has weakened and a new trend is developing. This may be preceded by a period of consolidation and then develop a new uptrend.
The consolidation area is easily identified on the Shanghai Composite Index chart. There is a strong resistance level near 3,000. This is the upper edge of the consolidation area. The lower edge is at 2,600. There is a high probability the market will move in a sideways trading band for several weeks before developing a breakout above 3,000. A market consolidation between 2,600 and 3,000 will provide short-term rally trading opportunities. This indicates investors are accumulating stocks and getting ready for the development of the next section of the longterm uptrend in the Shanghai market. This has been a savage sell-off but, the RSI divergence pattern shows the market can make a secret escape from the bear. The pattern of chart behaviour suggests this is not a bear market, despite the degree of retracement.
